Why Italian fiscal austerity won’t work

Not now, at least. You don’t have to buy into the more extreme forms of Keynesian economics. In the short run, what the country needs is more revenue, relative to expenditure. If you cut the government expenditures, in the short run revenues go down, including tax revenues. Maybe you substitute in some private sector outputs for public sector outputs and furthermore maybe those private sector outputs bring higher utility to the citizenry. But they don’t bring higher revenue, not in the short run.

The financial crisis, now exacerbated by a revenue shortage, destroys the economy before the potential gains from the expenditure-switching have a chance to kick in. Furthermore, if the broader economy is dysfunctional, the gains from expenditure-switching to the private sector may not show up even in the medium run. Growth-enhancing reforms can take many years to pay off, as we see from the histories of New Zealand, Chile, or the ex-communist countries. Yet even the Italian two-year note shows default risk, yielding twice as much or more as the American 30-year bond.

That said, more government spending probably won’t work either, unless you think that spending is extremely effective in targeting unemployed resources, which in Italy I believe it is not. Neither contractionary nor expansionary fiscal policy will succeed.

The only answer, if that is the right word, is a central bank. Right now central banks need to be doing everything they can to avoid a second Great Depression. I talk to many smart people, and I am continually surprised how many of them do not realize the urgency of the current situation.

By the way, some of the worst features of the Italian economy — paying people to do nothing, or to do the wrong thing — can in the abstract be described as “automatic stabilizers.” Automatic stabilizers play an important and largely positive role in macroeconomic response, but if not designed properly they too can bring or hasten downfall. The automatic stabilizers in Italy have thwarted productive incentives and thus lowered the growth rate. And furthermore, dismantling some of those automatic stabilizers eventually needs to be done, but in the short run again could hurt revenue. When a country uses automatic stabilizers for growth-damaging ends, it paints itself into an especially difficult corner. How to move forward?

The economic policies of the Nordic countries look better all the time, and actually you can add the United States to that list, believe it or not.

If economic disaster like US recently is on the good list, it’s only because Eurozone is even worse.

NylundNovember 10, 2011 at 1:15 pm

Out of curiosity, which countries top your list?

mjw149November 11, 2011 at 11:24 am

It’s an interesting point I haven’t heard before. I consider Europe’s troubles, similar to the US, as due to broken politics. Not because politics necessarily creates out of control spending. But the EU is obviously structured too loosely, like our own Articles of Confederation once upon a time. The US kind of hit on that with the vast chasm between the (largely) rural moral conservatives and (largely) urban progressives, making us quite dysfunctional every 20-30 years or so. Europe need true federalism, which wouldn’t have ended this crisis immediately or even avoided it, but would have provided a lot of certainty that is currently lacking. By the same token, the US could do with a little more unity or a new state-level proportional apportionment scheme for the House for more diversity.

So the Scandinavian point is quite interesting. They’ve always gone their own way, and they have natural economic advantages (like Canada I would argue). But they also are politically superior for similarly ‘lucky’ historical reasons, i.e. very monoethnic and regionally compact.

E. BarandiaranNovember 10, 2011 at 6:33 am

Tyler, there are too many elephants dancing very close to you but you prefer to ignore them and pay attention to Italy. Is that your comparative advantage?

john haskellNovember 10, 2011 at 8:32 am

On Tyler’s behalf let me assure you that Italy is the closest “elephant,” or if you prefer, “ticking time bomb” to him, and to anyone else in any economy that is linked to the economy of the Eurozone (which is a lot of people). Oh and by the way – he’s right.

E. BarandiaranNovember 10, 2011 at 9:53 am

Relax, I understand that for fear-mongers Italy is the Flavor of the Day. Just remember that they take advantage of your ignorance.

RahulNovember 10, 2011 at 10:02 am

Ignorance? Strong words.

In the short run I don’t think there’s any argument that Greece and Italy (and maybe even Argentina?) are closer to impending disaster than the US is.

ChrisNovember 10, 2011 at 10:13 am

We’ve got Big Ben.

Tyler CowenNovember 10, 2011 at 10:27 am

We serve the Flavor of the Day! (but not only…)

Andrew'November 10, 2011 at 11:06 am

The scary version is it will allow our leaders to hit the snooze buttion. Maybe since economists have a stone tablet above their door that says “no evidence of crowding out” we can call this “crowding in.”

RobNovember 10, 2011 at 6:55 am

“But they don’t bring higher revenue, not in the short run.”

Why is that?

“dismantling some of those automatic stabilizers eventually needs to be done, but in the short run again could hurt revenue.”

Why is that if they’re paid to do nothing?

n=1November 10, 2011 at 8:55 am

Because the 20 traffic officers in that mountain town of 800 (described in that great nyt article a few weeks back) now don’t have an income, on which they don’t pay tax. Plus, they no longer have the money to buy the cappucinos while sitting in the cafe while not directing the nonexistent traffic.

CliffNovember 10, 2011 at 9:06 am

It does seem like it would have to be a net positive revenue effect. You give a salary of X and collect whatever, .5X in taxes, then that money goes around and helps businesses and they pay taxes. But it’s not going to end up being more than X in tax revenue, that doesn’t make any sense.

Dan H.November 10, 2011 at 11:37 am

What are the unemployment insurance policies there? One of the problems with government downsizing as a short-term austerity method is that all those laid-off government workers are just going to turn around and apply for unemployment insurance, which is still a drain on the government’s coffers.

ZephyrusNovember 10, 2011 at 11:44 am

It can make sense. Paying that salary could create a potential market, cappuccinos for lazy government employees. Someone whose skills were previously unused or underutilized puts in more work in order to satisfy that demand and make a buck, in turn creating a new market for “lawnmowers for suppliers of cappuccinos to lazy government employees.” Each step brings added revenue, and there’s no reason, per se, that the new revenues generated by money circulating has to add up to less than the initial salary.

Indeed, that’s the entire basis of both the Keynesian multiplier and the Laffer Curve, which whatever you think of it does exist.

That isn’t the issue here, though, of course. What would happen is that by disrupting the currently existing economic structure, it would increase uncertainty and destroy value, as time and effort have been spent to create and know the “cappuccino for lazy government employee” market. Eventually it would recover, but when you’re starving on an island you don’t turn down McDonald’s because it’s unhealthy.

The Anti-GnosticNovember 10, 2011 at 11:55 am

It can make sense. Paying that salary could create a potential market, cappuccinos for lazy government employees. Someone whose skills were previously unused or underutilized puts in more work in order to satisfy that demand and make a buck, in turn creating a new market for “lawnmowers for suppliers of cappuccinos to lazy government employees.” Each step brings added revenue, and there’s no reason, per se, that the new revenues generated by money circulating has to add up to less than the initial salary.

What you’re describing is the whole structure of production being warped to satisfy demand for cappucinos by bureaucrats with nothing to do. Eventually, the malinvestments pile up to the point that no real wealth is being produced and the structure crashes.

The activity is dependent solely upon a continued infusion of new dollars and artificially cheap credit because nobody will voluntarily pay for government clerks to sit around and drink coffee. It’s actually destroying wealth, because all other sectors are now that much poorer from resources being diverted to supply cappucino to bureaucrats with nothing to do.

Housing bubble, education bubble, sovereign debt bubble. We are going to learn this lesson, like it or not.

CliffNovember 10, 2011 at 3:02 pm

No, it’s not the Keynesian multiplier or the Laffer Curve. The Keynesian multiplier would say that reducing government spending by X reduces GDP (not tax revenue) by more than X (multiplier greater than 1). If spending an additional X would bring in tax revenue greater than X, as you are suggesting, all we would have to do is spend more and the deficit would go down. I don’t think anyone seriously proposes that.

The Laffer Curve says that at some point, reducing marginal tax rates can increase revenue. That’s very different from saying that spending more money can by itself raise enough revenue to cover that spending and then some.

Michael G HellerNovember 10, 2011 at 7:01 am

Instant misshaped economic sociology rant here goes:
You are talking as though all that matters is the government balance sheet, or active government designs to shape private behavior. You accept the Keynesian premise that in emergencies like this government spending substitutes for private spending and makes the crisis (symptoms) go away allowing time to reform the structures after which true market economy emerges again. And, sure, everyone can agree on a long term where single or multi-country central bank action in the context of fiscal federalization would avoid break up and default. You are leaving out the existential side of situation, subjective perceptions where technocracy and economics won’t reach. There is heaps of (real) money out there in private hands. It is waiting for one of two things: guaranteed total unequivocal bail out OR meaningful meltdown and losses across the board (obviously falling most heavily on the most dysfunctional societies). Once either of these are done and dusted private money will pull its head out and go to work again. Since politicians cannot easily agree on quick macro-institutional emulation and scaling up of northern european-style governance structures that would enable the first option, meltdown and liquidation, ripping the bandaid off quickly, may the optimal evolutionary outcome. It seems as though every day the press wakes up and identifies new triggers for the latter to occur, but still no one pulls the trigger. One day soon a finger will simply slip. If only the bandaid had been torn off a year ago, two years ago, or three, four. Blame the Keynesians and their close involvement in the political cycles of decaying welfare states for that.

By the way I’m not sure what you mean by ‘destroy’ the economy. This is typical of the armageddon language employed by Keynesians and Sarkozy. There is destruction within the economy. Only nuclear destruction makes countries or economies cease to exist. As you and others have pointed out, Argentina did not cease to exist, only parts of it mutated.

AnonNovember 10, 2011 at 7:18 am

I agree with you, but fear that the same was true in 1932.

Andrew'November 10, 2011 at 9:36 am

Being a terrible credit when everyone else is also may be different than being a terrible credit when everyone else is trusted.

There may be heaps of money in private hands because they cut their expenses years ago.

RahulNovember 10, 2011 at 7:09 am

So what exactly is Tyler’s prescription for the ECB. How should they act?

GarethNovember 10, 2011 at 7:51 am

Target nominal GDP growth of at least 5% for all EU countries, and back it with a threat of unlimited QE. Italy needs a primary surplus of 6%+ with current yields. That drops to around 3% if NGDP growth rate goes up from predicted 2.5% to 5%.

And back in reality, they could at least raise the inflation target to 4%.

Anti-gnostic, couldn’t one make the same criticism of your prescriptions to “liquidate the ‘automatic stabilizers'” and so on? They don’t seem to me any less glib than what Gareth said.

The Anti-GnosticNovember 10, 2011 at 10:11 am

It’s so simple even an economist could do it: don’t do anything. The debts will be discounted to their actual value, real savings will replenish instead of getting sucked down a black hole of government pensions and make-work projects, capital will go where supply/demand dictate rather than where government economists dictate.

Also, bureaucrats and bankers will have to find work at a rate commensurate with their marginal productivity. Italy should therefore scrap its minimum wage laws.

rplNovember 10, 2011 at 10:41 am

Anti-gnostic, I understood you to be criticizing Gareth for making a problem that is actually very complicated sound as though it will be simple to fix. I don’t see how your prescription is any different in that respect. Your presentation of the idea certainly doesn’t inspire confidence that you’ve done any serious thinking about its consequences, and the fact that you chose to go with rudeness right out of the gate (and to double-down on that strategy in your followup) suggests that you’ve little in the way of persuasive arguments to back it up.

For starters, let those “automatic stabilizers” get liquidated. This is what the market has been trying to do; social democratic governments are trying to make water run uphill.

“Automatic stabilizers;” is that what they’re calling Keynesian hole-digging schemes these days?

The Italian government has pulled all its future income forward and spent it. That’s what debt is; that’s why debt should be avoided and economists need to drop this unfounded and harmful macro/micro dichotomy.

CoreyNovember 10, 2011 at 8:19 am

“The only answer, if that is the right word, is a central bank. Right now central banks need to be doing everything they can to avoid a second Great Depression. I talk to many smart people, and I am continually surprised how many of them do not realize the urgency of the current situation.”

I’m genuinly surprised by how frightend reading those sentances made me. I seriously felt a shiver go down the back of my neck.

Steven KopitsNovember 10, 2011 at 8:20 am

I think we need a more detailed exposition of the finances of Italy, maybe by year 2007-2012:

If the argument is made that there is nothing Italy could do to prevent default, then we really need to see the numbers presented in greater detail, because surely this must have been true six months or a year ago as well.

Robert PaulNovember 10, 2011 at 8:54 am

In small amount stimulus may be helpful, since it can provide a temporary psychological boost to the economy. However, the larger the stimulus, the worse the policy will be for the economy because of corruption and a misallocation of resources. When investing in something with a negative return on investment, larger amounts would be worse. We lose money on each item we sell but we make it up in volume.

Targeted nominal GDP would be as wise as price controls. Manipulating prices is unlikely to provide an environment where rational investment and capital allocation decisions can be made. There are always con artists trying to steal money and the economy does particularly poorly when that con artist is the government. Reallocating money from people who saved for their retirement, i.e. the large pools of money in institutions, to the government, which has shown itself to be poorly qualified to make capital allocation decisions, is folly.

Italy needs structural reform to remove the corruption, improve flexibillity the employment market and the capital market. I am surprised that no one is suggesting what most people and organizations do when they get into debt problems. Italy should have asset sales. They should sell off the companies that the government controls. I know Greece’s government owns many business and a lot of land, and I would suspect that Italy does as well. The United States could probably get out of its debt problem tomorrow if it sold Alaska, and it is feasible since the U.S. bought it from Russia and also bought land from France.

Also, the United States really needs to reform the bank capital requirements. When the government raised the capital requirements, the banks put a lot of small businesses out of business. It happened to my father, who lost everything included his house. After more than a year of dealing with the environmental regulation, he is trying to sell the building which was appraised at $750K, but will not sell for the $200K that is owed to the bank. If someone could explain how inflation or government spending would assist, I am willing to listen.

Ted CraigNovember 10, 2011 at 9:05 am

“The economic policies of the Nordic countries look better all the time”
I would argue the populations of the Nordic countries look better all the time.

Perhaps you can help me. Which group do you think wins the contest for ability to hijack any discussion on the Internet to their own noxious ends: the Race Realists / HBD enthusiasts, or PUA / Game followers? (Is every single thing under the sun explainable by group differences in IQ, or by sex differences and one’s status as an Alpha or Beta male?)

Ted CraigNovember 10, 2011 at 10:50 am

Let me explain it to you this way, Geoffy. Culture matters.

RahulNovember 10, 2011 at 11:01 am

Something that puzzles me is that the “exports as a percent of GDP” metric for Italy is twice that of USA. Gapminder data ca. 2009. They must be doing something right? 29% versus 12%

Ted CraigNovember 10, 2011 at 11:27 am

Why does that puzzle you? Italy has a strong manufacturing base, good agriculture land and high-end artisan goods (from handbags to sports cars). But the nation also leads Europe in categories such as bribery and unpaid parking tickets in NYC. Government is about governance.

Ted CraigNovember 10, 2011 at 11:30 am

By agriculture, I don’t mean for general use. They import food. But what they do produce, olive oil and wine, is lucrative for exports.

ChrisNovember 10, 2011 at 11:55 am

The US is much bigger than Italy. The bigger you get, the less you export relative to the total amount in the system. At the limit, the Earth’s exports as a percent of GDP are very small.

The Anti-GnosticNovember 10, 2011 at 12:13 pm

The Italians are doing plenty right. They are smart, creative people who appreciate things like family, Church, locality, aesthetics, etc. When the government and its patronage network collapses, the Italian people will still be there.

I do wonder if there are some under-remarked issues with this entity called “Italy.” I think the North-South divide may be a lot wider and more intense than non-Italians realize.

Multiculturalism doesn’t seem to be working out so well.

RahulNovember 10, 2011 at 12:31 pm

Anti-Gnostic mentions the Italian appropriation of the Church. Classic example that religion and morality are often orthogonal axes.

RahulNovember 10, 2011 at 12:33 pm

typo…”appreciation”……

msgkingsNovember 10, 2011 at 2:01 pm

Rahul, it’s pretty simple: Italy is a smaller nation than the US but it’s part of a currency bloc with a bunch of neighbors. Goods shipped to the Eurozone are exports even for Italy. I’m actually surprised it’s only 29%.

Got little to do with competitiveness. I’d imagine Estonia has well over 50%.

CliffNovember 10, 2011 at 11:41 am

I wouldn’t call them “noxious ends”, but the race realism thing of course comes up more often on this global economics blog.

BernardoNovember 10, 2011 at 9:05 am

Tyler, do you sleep (You posted today at 2am and 6am)? Either that or you’re not in the US.

Curiously enough, for the high yields on their bonds, Italy has a primary surplus (before debt interest payments) for its budget (as does Spain also), which is more than can be said of the US right now.

NealNovember 10, 2011 at 9:53 am

And yet, somehow, the bond market rates “Italy defaults in the next two years” as more likely than “US defaults in the next thirty years.”

claytonNovember 10, 2011 at 11:29 am

The US has its own currency; Italy does not.

MPNovember 10, 2011 at 10:11 am

“In the short run, what the country needs is more revenue, relative to expenditure. If you cut the government expenditures, in the short run revenues go down, including tax revenues. Maybe you substitute in some private sector outputs for public sector outputs and furthermore maybe those private sector outputs bring higher utility to the citizenry. But they don’t bring higher revenue, not in the short run.”

You need higher revenue relative to expenditure. Lowering expenditure doesn’t need to raise revenue. It can just LOWER EXPENDITURE and still improve the budget balance. I buy the argument that you don’t want to do radical reform in a weak economy, and I’m really coming around to the argument that this is a monetary issue at the moment. But I don’t at all get the logic of that opening paragraph.

Andrew'November 10, 2011 at 10:29 am

I suppose if the government couldn’t tell what was useless before they can’t do it in a hurry either.

I the political will could be mustered to replace the automatic stabilizer with some kind of wage subsidy wouldn’t that be much better?

Tom GreyNovember 10, 2011 at 11:27 am

There is a current crisis because of:
Unsustainable Government Spending.

To continue and even increase such spending seems irresponsible.
What part of the Great Depression must be avoided?
Hunger? I sincerely doubt the huge number of obese post-Christian “civilized” folk are really going to be hungry.
Clothes? There are plenty in second hand shops.
Housing? um, wasn’t there an (almost Marxian) over-production of housing?

How about bank depositors losing their money? Too late. The US people have been “saving” thru the build up in equity in their houses, based on rising house price values. Those “savings” have now been lost. Thanks to terrible gov’t regulation / false rating agencies / housebuyer greed & dishonesty / house financier greed & dishonesty …
Some $6 trillion in house value has disappeared, possibly not too different from what depositors lost in dying banks in the GDep (inflation adjusted $), tho likely a smaller portion of their total wealth (when clothes, cars, equip, etc. are included).

One of the worst problems during the GD was the difficulty in getting loans to start a new business. Where are the numbers on how many small companies are getting loans, vs getting turned down?
I think it’s still much easier now, than during the GD. And if gov’t would stop borrowing so much money, there would be more available to loan to business.

So … this time, right now, is the best time we have to start reducing the real problem.
Unsustainable Government Spending.

NAME REDACTEDNovember 10, 2011 at 12:14 pm

I call BS.

Tom GreyNovember 10, 2011 at 12:22 pm

… and in Italy, what is needed is the same as in most countries — more wealth creating jobs, funded by entrepreneurs looking to create net positive wealth, aka profit.

Not a central bank, but a lot more small businesses.
Like a) immediate “automatic wavier” of all EU and Italian regulations requested by new start up small businesses, for the next 3 years, except a clear contract with all employees that usual regulations and taxes won’t apply for 3 years;
b) 3 year exemption of all taxes by the new businesses,

d) For all transfer payments, replace a portion of the Euros, those more than 300/month, with Italian 0% bearer bonds, so that Italians become the lenders to the Italian gov’t.
(This would work for Greece, too; and also California)

what the country needs is more revenue, relative to expenditure.
The country, of Italian people, is different than the gov’t. The unsustainable gov’t ratio of higher expenditure than revenue comes down most quickly with less gov’t expenditure.

Yes, they really needed to fix the problem before now. Now the solution exacerbates the problem.

This is why Krugman’s talk about “bond vigilantes” and “confidence fairies” is so infuriating. The U.S. still at a point where massive austerity could save us before we enter a debt death spiral, but they want to blithely pretend the problems of Italy and Greece will never happen here.

Does this analysis imply Italy’s current amount of fiscal spending is just right (for the short term)? Otherwise, if fiscal contraction would be clearly worse by causing an immediate drop in revenue, what’s wrong with more fiscal spending?

Maybe confidence/expectations plays a role here — fiscal expansion would look like digging a deeper hole even if it otherwise would help, and contraction would scare consumers even more?

XenophonNovember 11, 2011 at 10:20 am

Actually, Italy’s economic problems are going to be tied to its falling population. Italians are disappearing. Italian women are having on average 1.3 children…below replacement level. By 2040, Italy’s population will consist mainly of retired people. No economic system now known, whether it uses a central bank or not, can overcome the simple math of demographics. And don’t think for a minute that immigration from alien civilizations will help. These folks may be nice, but they don’t create wealth once they arrive in the European welfare state. They simply increase the burden. Stand by for a system implosion on a grand scale.

SamNovember 13, 2011 at 6:11 am

immigration by skilled labour can help, i would think welfare handouts would be attractive only to unskilled labor who are unlikely to earn sufficient income in the labour market to make work worth their while.

SamNovember 13, 2011 at 6:12 am

unless we are talking about corporate welfare handouts to rent seeking affluent business groups